- 15 Marks
Question
One of your clients has seen many references to the “Cost of Capital” in the Business and Financial Times and has asked you to give him some guidance on what would be an appropriate figure for his organization-Zaytuna Ltd. The following information is available for Zaytuna Ltd.
Existing capital structure:
- Issued ordinary shares-12,000,000 GH¢12,000
- Retained earnings GH¢4,000
- 6% Preference shares GH¢2,000
- 9% Debenture repayable 2018 GH¢6,000
- Total GH¢24,000
Details:
- 9% Debenture: Issued in 2008 at par, Current price GH¢92, A similar issue if made now would require to be at GH¢90.
- Preference Shares: Preference shares have a par value of GH¢1 and were originally issued at 92p per share, Current price 43p, A similar issue if made now would require to be 40p per share.
- Ordinary Share: The market price of an ordinary share is GH¢7.00, GH¢6 million in dividends were paid this year which represented 75% of earnings, Earnings are expected to grow at an annual rate of 5%, If new ordinary shares were issued now, costs incurred would represent 25p per share and a reduction below market value of 50p per share would also be made.
- Corporate tax rate is 25%
Required:
Calculate Zaytuna Ltd’s Weighted Average cost of capital. (15 marks)
Answer
Note: Students will be awarded marks based on the cost of capital as determined by them. The following calculations will be relevant to this.
Debentures
Marginal cost after tax = coupon rate / proceeds of current issue (1 – tax rate)
= 9/90(1 – 0.25) = 7.50%
ALTERNATIVE SOLUTION
= 540,000 (1-0.25) X 100 / 5,400,000
= 0.075 X 100
= 7.5%
(3 marks)
Preference shares
Marginal cost = coupon rate / proceeds of current issue
= 6 / 40 = 15%
ALTERNATIVE SOLUTION
= 120,000 X 100 / 800,000
= 15%
(3 marks)
Issue of ordinary shares
Marginal cost = Dividend per share / net proceeds of issue + growth rate
= 50 / 625 + 0.05 = 13%
ALTERNATIVE
= 50 + 0.05 / 700 – (50+25)
= 13%
(3 marks)
Cost of retained earnings = dividend yield + growth rate
= 50 / 700 + 0.05 = 12.1%
Weighted average marginal cost of capital
| Source of finance | Capital structure GH₵ 1 million | Weight | Component Cost % | Weighted cost |
|---|---|---|---|---|
| Ordinary shares | 12 | 0.50 | 13.0 | 6.50 |
| Retained earnings | 4 | 0.17 | 12.1 | 2.06 |
| Debentures | 6 | 0.25 | 7.5 | 1.88 |
| Preference shares | 2 | 0.08 | 15.0 | 1.20 |
| Total | 24 | 1.00 | 11.64 |
(3 marks)
ALTERNATIVE SOLUTION
WACC
| Source of finance | Capital structure GH₵ 1 million | Weight | Component Cost % | Weighted cost |
|---|---|---|---|---|
| Ordinary shares (6.25@12m) | 75 | 0.923 | 13.0 | 12.0 |
| Debentures (0.9 @ 6m) | 5.4 | 0.067 | 7.5 | 0.50 |
| Preference shares (0.4 @2m) | 0.8 | 0.01 | 15 | 0.15 |
| TOTAL | 81.2 | 1.00 | 12.65 |
WACC formula can also be used to arrive at the 12.65%.
- Tags: Cost of Debt, Cost of Equity, Weighted Average Cost of Capital
- Level: Level 2
- Topic: Cost of capital
- Series: NOV 2017
- Uploader: Theophilus